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Europe wanders further into the unknown

Europe's elections have robbed the continent of its political cohesion in confronting the debt crisis. The global ripples have already struck here, with the Australian dollar plunge the first of the ramifications.

The plunge in the Australian dollar towards parity and the sell-off in the equity and bond markets is a sobering signal that the eurozone threat to world economic growth and financial stability remains real and substantial.

Ever since the worst of the original financial crisis was passed, the Australian dollar has been a barometer of both perceived risk and the outlook for the global economy, with capital flowing towards it in pursuit of the relatively strong returns during periods of calm and fleeing at each outbreak of instability and heightened risk.

Monday's sell-off was obviously linked to the outcome of the French and Greek elections and the rejection of the begrudging consensus in Europe that the pathway from the brink of a eurozone collapse was one of pan-eurozone austerity. The Dutch government collapsed last month after its coalition failed to agree on a plan to shrink its budget deficit.

The fresh instability and uncertainty in Europe and last Friday’s weak employment numbers in the US aren’t positive for the world economic outlook, or for the commodity prices and China-led demand that have underpinned the booming resources sector in the Australian economy.

Wayne Swan, about to unveil what’s touted as a highly contractionary budget, might have to start preparing for another emergency stimulus package.

It was perhaps inevitable that the austerity programs, agreed to by Germany, France, the European Commission and the European Central Bank and imposed on the rest of the eurozone, would fail.

Popularly elected or anointed governments in member states like Greece, Spain and Italy had become wildly unpopular, with their populations rioting in the streets, as the European recession had worsened.

The prospect of forcing reductions in budgets deficits across the eurozone below 3 per cent by 2013 at a time when unemployment in countries like Greece and Spain is above 20 per cent and youth unemployment is approaching 50 per cent was destined to create political upheaval and a derailing of the fiscal strategy.

The emphasis on growth over austerity that propelled the socialist leader Francois Hollande to power in France at the weekend was inevitably appealing, despite its obvious shortcomings, the most obvious of which is who is going to fund that growth, given the debt and deficit-laden state of the region.

International investors will be increasingly leery about the prospect of a repeat of the Greece experience, where the restructuring of Greece’s sovereign debt imposed massive haircuts on the value of their holdings.

Without the confidence of bond markets, not only would it be more difficult and expensive to fund growth spending but the cost of refinancing existing maturing debt will soar and worsen the debt and deficit vice that has destabilised the eurozone.

With Germany, which has benefitted from the weaker euro, holding its hard line on the need for austerity, the potential for a break-up of the eurozone has strengthened, although forcing its customer nations into recession or out of the eurozone is probably not in Germany’s interests, either.

Europe’s inability to maintain a consensus around the austerity strategy (which in any event wasn’t working because it was contracting the weaker economies and making their deficit-reduction and debt-servicing tasks even more difficult) and its failure, so far, to develop and fund a plan that provides short term stimulus but a credible longer term return to fiscal stability, means that it is now in an even more precarious position than it was when the eurozone crisis first erupted last year.

Its plight has been exacerbated by the reality that it didn’t tackle the fragile state of its banking system with vigour while it could, instead encouraging the banks to load up with more sovereign debt financed by near-costless funds from the ECB. That vastly magnifies and complicates any attempt to devise a new escape route from a potential dominos-like eurozone collapse.

Hollande’s growth rhetoric will unsettle investors in French bonds. France is already running a significant fiscal deficit and lost its prized AAA credit rating from Standard & Poor’s earlier this year. It has unemployment above 10 per cent despite public spending that amounts to more than half its GDP.

A spike in its borrowing costs would be unpleasant, although Hollande’s strategy appears to be to fund his programs by increasing taxes on the wealthy, which could lead to a greater outflow of capital from the French economy.

Spain, Italy and France have economies and debts that make them both too big to be allowed to fail but too big to bail out.

It isn’t clear what the middle course might be if the austerity versus growth dilemma can’t be reconciled and a credible plan for restoring stability to the region developed.

It is very clear, however, that the eurozone is again in an extraordinarily fragile and vulnerable position and that a failure to convince the rest of the world, and its own population, that it does have a plan could have very unpleasant consequences for Europe and the rest of the world.

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